In early November 2022, the IMF published a working paper on a multi-currency exchange and contracting platform (known as X-C) that the authors said could reduce the cost of FX transactions.
X-C envisages a multi-currency environment where intermediaries act as broker-dealers and compete to attract trade from clients. The proposal describes multi-currency auctions as a robust solution that generates competitive outcomes and can be implemented entirely through smart contracts.
The proposal allows for centralized order-book exchanges for dealers, but with dealers also competing on the common platform. It advocates that all participants should be allowed to act as dealers and offer terms of trade on the platform and that posted prices should be hard commitments, with dealers not allowed to renege from their announced terms of trade.
The IMF suggests the centralization of information and exchange of FX trading could contribute to improving markets by boosting transparency and by creating incentives to increase competition.
However, Andrea Michael, director of institutional sales at StoneX Pro, suggests that the existing FX market is already pretty efficient in terms of pricing, and that conclusions around cost are often drawn based on very narrow definitions.
“For whom will costs be reduced?” he says. “Transaction costs for most institutional players in the FX market are closer to zero than for any other asset class – bid/ask spreads available in the over-the-counter market are much tighter and the fee structure lower compared to exchange offerings.
“It is unclear how or why this proposed centralized platform would reduce costs, other than for the most exotic currencies that do not have well-functioning FX markets. For G10 currencies, it is hard to see any serious applicability.”
This isn’t to say some large companies aren’t paying too much for FX – it is just that I wouldn’t blame that on the currently available execution platforms
Scott Bilter, Atlas FX
The FX market is very efficient for corporates, if they want it to be. Pricing can be tight if they execute the right way, although they may choose to not try to squeeze the last bit of potential efficiency for relationship reasons since their FX trading counterparties are almost always their credit facility banks and they may feel pressured to ‘reward’ these institutions with a certain amount of their FX business.
“This isn’t to say some large companies aren’t paying too much for FX – it is just that I wouldn’t blame that on the currently available execution platforms,” says Scott Bilter, principal at Atlas FX, adding that he would prefer all these transactions to be executed on their own merits, with no ‘loss-leader’ credit facility pricing to be made up for in other areas.
Bilter is sceptical about whether the introduction of contracts and policies to manage FX risks would be a welcome development for FX market participants given that the vast majority of the FX market is OTC, with exchange products not having the maturity that FX counterparties want.
“Sound legal contracts are already the cornerstone of the OTC FX market via Isda [International Swaps and Derivatives Association] or bespoke bilateral documentation,” adds Michael. “Again, this is a well-functioning system, so it is unclear what problem the IMF is trying to solve.”
On the issue of the feasibility of creating a centralized FX order book open to all dealers, where participants would have to honour any quotes they listed, Michael observes that in open-access markets what tends to happen is that the pricing defaults to the lowest common denominator, which is that liquidity providers must assume anyone using the platform is a high-frequency trader.
“Most estimates for open-access financial markets put the volume of high-frequency trader versus end users at around 80%,” he says. “Dealers are much more willing to show a tighter price to an end user – whose flow is random – than to a trading firm whose flow is likely to generate losses very quickly. The only ones who seem to benefit from an open-access market are trading firms.”
Bilter reckons quotes would get listed for only a fraction of a second and for modest amounts.
“I don’t think there would be much liquidity other than spot trades or forward trades that mature on the same dates as current futures trades,” he adds. “In other words, not suiting the needs of the OTC market.”
One aspect of the IMF’s proposal that has been well received, however, is its observation that spreads are typically high in illiquid FX markets and that lack of market depth can hamper spot-market liquidity and increase cross-border transaction costs.
